How Options Can Give You an Edge

How Options can give you an edge in trade?

Options are the fastest way to reach your trading goals. They enable you to trade in any market situation and generate high returns on low capital if you can control the associated risks. In this video, we will discuss real-world options strategies that will give you an edge in trading.

A Word of Caution:

Options are more complicated financial instruments than, say, stocks, bonds, ETFs, mutual funds, or physical assets like gold. So before you trade in Options, ensure that you get your basics in place.

The Options ‘Edge’

Despite their complications, options allow traders to do the following:

• Speculate – If you’re working with a forecasted outcome of an index or stock, you can use options to speculate on them with lower upfront costs as compared to investing in stocks or futures.
• Hedge equities – Like insurance policies, you can pair options with investments in an index or individual stock to provide a hedge against market volatility and limit losses to a certain amount.
• Earn yield – If you buy a company’s stocks and it pays dividends while you hold them, that would be a yield earned in addition to a return on price appreciation. Similarly, if you own stocks, you can sell call options on those stocks and collect a premium. You can think of this premium as an option-based yield.

Speculation is the most common use case for options. But to succeed at speculation, you need to have a well-rounded understanding of the ins and outs of options strategies.

Hedging and earning yield are limited to a few option strategies and are a subset of the strategies needed for speculation. A solid grasp of speculation will give you a detailed understanding of hedging and earning yield.

Using Options for ‘Speculation’

So how do you make money through speculation using options? Let’s walk through an example. Tata Motors was announcing earnings on Friday, 2 Feb, after market close. You believe that the company will beat earnings, and the market will react positively, leading to an increase in the stock price. You can do two things:

1. You could purchase shares in Tata Motors prior to the announcement. If things work out well, the price of the stock will rise once the market opens on Monday, 5 Feb. You could plan to exit the trade at the close on Monday. You could enter this trade on market close on the day prior to the earnings announcement (1 Feb).
2. You could instead purchase call options in Tata Motors prior to the announcement. While options on indices are available with weekly expiries, options on stocks are only available with monthly expiries. The next expiry for Tata Motors after the earnings announcement is for 29 Feb. Just like with buying stock, you could enter this trade on market close the day prior to the earnings announcement.

After you place your trade, you anxiously await the release of the earnings information. Fortunately, the numbers were strong with an 18% YoY increase in income and an 8X increase in earnings per share. When the market opened on Monday, traders demanded both the stock and the options, and the prices rose accordingly. Illustration 1 below is the chart for Tata Motors over those few days.

Illustration 1: Tata Motors Earnings

Let’s take a look at the specifics. For the stock trade, you could have bought Tata Motors for ₹878.50 at the close of 1 February. The next day’s closing price was flat in anticipation of the earnings release. As you can see in the chart above, the price gapped up dramatically on Monday as a result of the earnings announcement. The stock closed at ₹926.80 on Monday. As you can see in the table below, this trade did well. You would have made nearly 6% by holding this stock for only two days!

Illustration 2: Tata Motors Stock Price

For the option trade, you could have bought the at-the-money strike price of 880 at the close of 1 February. There is some new terminology here – don’t worry, we will discuss this throughout the course. The only thing you need to take away is that you entered into an option’s trade. The option contract cost only ₹34.55 compared to ₹878.50 for the stock. On Monday’s close, this option contract rose in price from ₹34.55 to ₹59.20. This is a gain of nearly 72%! This return is multiples higher than that of the stock.

Illustration 3: Tata Motors Option Price

Why would anyone not trade options when the return is so much higher? Because the risk is substantially higher. If the stock fell in value, you would still own the stock albeit at a lower price. An option contract has a finite lifespan. On expiration, there is always the chance that the option will be worthless. This would be a loss of 100%. You rarely see stocks fall in value by 100%. However, this is a common occurrence with options, which means that an extra level of diligence, planning, and education is required to be successful in options trading.

Hope the above example gave you a sense of how traders use options strategies in the real world.